XYZ Corporation has a deferred compensation plan under which it allows certain e

Question

XYZ Corporation has a deferred compensation plan under which it allows certain employees to defer up to 35 percent of their salary for five years. (For purposes of this problem, ignore payroll taxes in your computations.) PV Table (Round your PV factors to 5 decimal places. Round your intermediate calculations and final answers to the nearest whole dollar amount.)

a. Assume XYZ has a marginal tax rate of 35 percent for the foreseeable future and earns an after-tax rate of return of 9 percent on its assets. Joel Johnson, XYZ’s VP of finance, is attempting to determine what amount of deferred compensation XYZ should be willing to pay in five years that would make XYZ indifferent between paying the current salary of $18,800 and paying the deferred compensation. What amount of deferred compensation would accomplish this objective?

b. Assume Julie, an XYZ employee, has the option of participating in XYZ’s deferred compensation plan. Julie’s marginal tax rate is 40 percent and she expects the rate to remain constant over the next five years. Julie is trying to decide how much deferred compensation she will need to receive from XYZ in five years to make her indifferent between receiving the current salary of $18,800 and receiving the deferred compensation payment. If Julie takes the salary, she will invest it in a taxable corporate bond paying interest at 7 percent annually (after taxes). What amount of deferred compensation would accomplish this objective?

Deferred compensation

Explanation / Answer

Part 1 - Calculation of Compensation deferred

Step 1 - Calculation of after tax cost of salary

Step 2 - Deferring such salary will save $12220 now and the cost of $12220 after 5 year @9% After tax rate of return is -

Multiplication (1+r)n

Here, r = 9% or 0.09, n = 5 years

= (1.09)5 = 1.53862

Step 3 - Before tax salary cost which is deferred or deferred compensation

Tax rate = 35%

After tax cost of salary = $18802 = 65%

Deferred compensation = 100%

Part 2 - Calculation of deferred compensation

Step 1 - Calculation of after tax salary cost if julie take salary now

Step 2 - Calculation of amount after 5 years if julie invest in taxable bonds

= $11280 * (1.07)5 = $15821

Here, r = 7% or 0.07% & n = 5 years

Step 3 - amouny need to be received if tax rate is 40% in order to be indifferent towards salary and deferred compensation

Tax rate = 40%

Amount receivable after 5 years investment = $15821 = 60%

Particulars Salary $18800 Tax rate 35% After tax cost of salary ($18800 - 35%) $12220

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